Captive Insurers: An Introduction

Introduction to Captive Insurers

• Captive insurance market expansion occurred in 2012, with increased captive formations and domiciles
• Licensed captives globally reached 6,052 by 2012, up from 5,807 the prior year
• The growth in captives to 6,000 worldwide was not expected by Japanese insurance and risk management experts
• The total number of captives established and owned by Japanese firms is about 80
• The number of Japanese captives is decreasing
• Japanese firms are resistant to establishing captives
• The number of Japanese captives should be over 1,000, given the size of Japan's economy
• Factors beyond finance explain the reduced captive motivation
• Japanese firms can create value through captives instead of traditional insurance
• This study seeks to analyze the hypothesis using Japanese captives in European domiciles
• Research on Japanese risk management academics and professionals is important
• A qualitative method is used to explore European captive domiciles and the advantages of forming captives in Europe
• The study quantifies the level at which a Japanese firm creates value via a pure captive insurer in a major European domicile using a scenario approach
• Domiciles of Guernsey, Luxembourg, Dublin, and Ireland are reviewed

Defining Captive Insurance

• A captive insurance company is a retention fund with its own corporate identity that acts as a subsidiary of a noninsurance parent firm
• A captive insurance company has been defined as one owned by a noninsurance parent company/companies
• A captive insurance company underwrites the insurance business of its parents directly or through the use of reinsurance contracts

Advantages of Establishing Captive Subsidiaries

• Investment income from reserve funds goes to the parent company, not an unrelated insurer
• Captives offer certain tax benefits over typical insurance or retention methods
• Captives provide specific coverages hard to obtain or expensive in the conventional insurance market
• Captives can access the reinsurance market
• Captives offer lower underwriting costs than unrelated insurers
• Captives motivate a company to effectively control losses

Incentives to Form a Captive

• Forming a captive outweighs the incentives of conventional insurance
• Captives may be formed with the purpose of securing insurance on advantageous terms
• Owning a captive insurance company can improve a parent firm’s ability to negotiate for terms and conditions of an insurance contract with an insurance company
• Benefits include reductions in premiums for large deductibles, competitive pricing, or coverage of difficult-to-place risks
• Captives may represent a genuine alternative to insurance
• "Risk finance" has become a popular term for finance risk

Risk Transfer Methods

• Financial and insurance markets have developed ways to transfer or finance risk, like catastrophe bonds, contingent debt, finite risk, contingent equity, credit default swaps, and weather derivatives
• Captives are an alternative financing scheme which allows corporations to retain risk and receive funding from corporate family members, diversifying the financing risk and risk management

Captives for Small to Medium Enterprises

• Captives protect operating businesses from higher taxation or creditors
• They also provide wealth transfer transactions
• Wealth can be transferred from a business owner to family members through a captive
• Countries with high inheritance tax rates, up to 50% in the US and Japan, find this feature attractive
• Some captives function as conduits for wealth transfer, according to interviews with consultants at the Captive Conference in Chicago in 2012
• Captives can be formed and owned by the children of the business owner

Tax Implications

• If the children are over 21, captive activities are not attributable to the owner of federal gift; US taxes are not applicable
• Insurance premiums paid to a captive are tax deductible
• Premium transactions successfully transfer the owners’ wealth to offspring using the offspring-owned captive
• The increase in micro- and mini-captives in Utah and Anguilla stems from the wealth transfer function
• Business Insurance statistics rank Utah as the second-largest captive domicile in the US and sixth globally, with 287 captives
• Anguilla is ranked fifth, with 291 captives
• Tax avoidance regarding wealth transfer and the use of captives will be a significant future political issue

Regulatory Environment

• The favorable regulatory environment results in increased captive demand
• Captives in the US face tax issues and challenges, with uncertain tax laws
• Court battles between the IRS and captive owners dispute the definition of "insurance"
• Courts use to the US Supreme Court’s explanation that states "Historically and commonly insurance involves risk-shifting and risk-distributing"
• The subsequent issue is determining which factors constitute risk shifting and risk distributing
• The IRS unofficially assured captives would not be challenged if underwriting at least 30% third-party risk
• Revised guidelines set the safe harbor at 50% third-party risk
• The risk distribution requirement is met if captives underwrite at least 50% third-party risk
• Captives meet this by accepting quality reinsurance risks or selling reinsurance to another insurance company and receiving a premium
• The IRS would challenge a captive that does not act as an insurance company
• Domicile states offer rigid procedures or advice for captive registration
• The IRS will not initiate a challenge once a captive is registered in a domicile and conducts genuine insurance business
• A regulatory environment allowing corporations to operate captive businesses without legal challenge from the IRS explains the increase in US captives

Summary of Captive Formation

• There are a number of rational reasons why corporations form captives onshore and offshore
• Corporate demand has resulted in an increase in the number of captives to over 6,000, with an additional 100 to 200 captives forming each year

Literature Review on Captives

• There are over 6,000 captives worldwide with around 90 Japanese firms involved
• Research is lacking on Japanese captives compared to US and EU firms
• Studies on U.S. and European captives can only be partially applied to Japanese captives
• Japan's business environment and legal liability exposure for its corporations differ
• Studies have looked at the benefits/challenges of captives worldwide, global trends fueling growth, and captives' dynamic with other financing methods
• The corporate demand for Japanese captives has been demonstrated through qualitative analysis

Captive Performance

• The lack of public data on captive performance regardless of nationality may have triggered conflicting conclusions regarding their ability to generate value for parent firms
• Event study methods are used to study whether a captive insurer's establishment creates value for its shareholders
• There is non-significant negative drift of abnormal return on the parent's stock
• This may indicate an amount negligible to all stockholders might be significant for certain managers
• The welfare gain derived is likely to benefit the managers of the parent firm rather than the shareholders
• Firms with captive insurers are more likely to experience manager-owner conflicts than firms that do not form captives
• Captive formation is partially attributed to managers' benefits
• The incorporation of captive insurers is somewhat detrimental to value

Monte Carlo Simulations

• Employed to identify sustainable conditions where captives exhibit a high probability of creating positive shareholder value
• Captives, on average, have a low probability of generating shareholder value
• Well-managed captives, however, have a high probability of generating shareholder value
• Captives of parents with low systematic risk have the highest probabilities of creating value
• Shareholder value creation with a similar methodology was used for a Japanese captive established in Guernsey, Bermuda, and Hawaii; findings were expanded into enterprise risk management and finite risk schemes
• There is a higher likelihood that a captive generates economic value for its Japanese parent firm especially when operated over multiple years
• The captive delivers approximate break-even economic value when reinsuring its entire book of business
• The captive generates a high level of economic value by adopting a higher level of operating risk
• The value-maximizing strategy is for a Japanese corporation to establish its captive in Bermuda, while the risk-minimizing strategy is to establish its captive in Guernsey
• Bermuda offers favorable risk-return tradeoffs for Japanese captives compared to Hawaii

Study Expansions

• Expands methodology with respect to Japanese captives established in European domiciles (Guernsey, Luxembourg, Dublin, and Ireland)
• Describes the feasibility of Japanese firms expanding into European markets through a captive vehicle

European Captive Domiciles

• The onshore and offshore global captive market can be divided the captive market into four regions: U.S./Canada, the Caribbean, Europe, and Asia-Pacific.
• Captive markets for the four regions: U.S./Canada (36.9%), Caribbean (44.1%), Europe (16.8%), and Asia-Pacific (2.3%)
• The Caribbean market is the largest, followed by the U.S./Canada, and Europe
• The Asia-Pacific market is still in the infant stage
• There are no captive domiciles within Japan
• Nago, Okinawa declared to be a domicile in 2004 but no captives established.
• The first domicile in Japan failed

Domicile Characteristics

• Each market possesses unique characteristics
• The Caribbean market includes Bermuda and the Cayman Islands is the world’s largest and second largest captive market
• Captive markets are offshore domiciles providing: corporate income tax-free environments, flexible/business-friendly regulations, natural resources, and entertainments
• Resources attract substantial insurance companies, reinsurance companies, and financial institutions (banks, hedge funds, and special purpose vehicles for investment)
• Domiciles offer "one-stop shopping" due to established business infrastructure
• Hamilton in Bermuda is an example

US and Canada Captive Markets

• The US and Canada captive market attracts mostly US and Canadian firms
• The market provides US companies: visible state registrations, political stability, and a lower level of legal liability
• Safety, comfort, convenience, and easy access are provided for US and Canadian firms.
• Vermont attracts captives by offering flexible registrations/captive seminars/annual conferences
• Vermont is committed to the institutionalization of captive registrations and Risk Retention Groups are registered according to a state captive law

European Captive Market

• Began in the early 1920s with the establishment of group captives.
• Group captives are jointly owned by two or more parents and underwrite the risks of those parents
• Domiciles attract: Protected cells or rent-a captives (Protected Cell Companies "PCCs" or Incorporated Cell Companies "ICCs) that resemble group captives
• Certain domiciles focus on reinsurance captives and equalization reserves while others accommodate direct captives (Dublin, Gibraltar, Nordic nations)

Guernsey

• A Channel Island is dependent on the UK but not subject to UK taxes or EU legislation
• It initiated captive business in 1922
• Protected by the UK military, they offer the island offers: Flexible tax structure, well-established infrastructure, and close proximity to London/European countries
• A domain for PCCs and ICCs
• Guernsey passed the Protected Cell Companies Ordinance in 1997, amended 2002
• Recent legislation for ICC was introduced in 2006
• Protected cell companies or incorporated cell companies are rent-a-captives offering less expensive and easier captive formation than pure or group captive formations
• Rent-a-captives are rented by various firms
• PCCs possess a special provision separating assets/liabilities in each account/cell to ensure the bankruptcy of one cell does not affect another
• Individual cells in incorporated cell companies are registered to retain benefits
• Companies in Guernsey first use PCCs or ICCs to deal with establishment costs or face significant difficulty such as high

Captives Including PCCs

• 333 captives including Guernsey PCCs/ICCs in Guernsey by 2012
• The number of PCCs increased to 320 by the end of 2012
• Guernsey had over 300 total cells in PCCs alone in 2010; represents a significant percentage of captive insurance market

Luxembourg

• Luxembourg is a vibrant financial center near Germany, France, and Belgium
• Luxembourg attracts multinational corporations establishing headquarters in Europe (Amazon.com, Rakuten, Delphi)
• One of world’s foremost captive domiciles
• The current number of captives is 238 (8th largest globally, 2nd in Europe as of 2012)
• Initiated captive business in 1984 when its captive reinsurance market opened
• It offers business-friendly regulations, well-established infrastructure of banking, investment actuarial, accounting/legal services, political stability, and close proximity to the London and European markets

EU Captive Business

• Luxembourg initiated captive business to offer European captive owners a domicile in the EU that would allow them to do business onshore
• The country has established a favorable business environment with normal tax policies for captives
• Luxembourg has become a fully diversified international financial center

Reinsurance Captives

• A factor of Luxembourg’s business is the predominance of reinsurance captives.
• Reinsurance captives utilize a fronting insurance company between the parent and captive
• Reinsurance captives are influenced by the traditional insurance market or the fronting local insurance market
• If the local market is smooth with low premiums, the parent is less willing to transfer premiums into the captive
• Conversely, if the local market is experiencing increasing premiums, the parent is more willing to transfer risk into the captive
• This is facilitated by altering the amount of reinsurance that the captive sells to the fronting insurance company
• If a Japanese firm located in Japan establishes a captive overseas, it uses a licensed fronting insurance company that creates a reinsurance contract with the offshore captive
• Japanese insurance regulations require insurance contracts be made only with licensed companies, therefore, reinsurance captives are normal

Building Equalization Reserves

• Captives build equalization reserves where they set up accounts that build tax-suspended reserves
• Extra reserves are tax exempt and accumulate capital in periods of scare claims that fund larger claims later on
• Equalization reserves allow captives to accumulate substantial capital without paying taxes

Dublin, Ireland

• Dublin, Ireland's capital, shares the island with Northern Ireland (part of the UK)
• Ireland became independent in 1949
• Ireland is a member of the European Economic Community (EEC)
• Ireland initiated captive business in 1987 when it opened the International Financial Services Centre in Dublin
• Leading financial institutions have located in Dublin Zurich, Ace, XL, Generali insurance companies, Deutsch, Citi, Sumitomo banks, Merrill Lynch
• Dublin has advanced infrastructure and business-friendly regulations for financial institutions (including captives)
• Dublin is recognized as an international financial center inviting companies primarily from Europe, the U.S., and Japan
• Ireland accommodates 141 captives - ranks fifteenth in the world, third in Europe as of 2012

Regulations

• Dublin is popular for captives because direct writing captives can be formed allowing to issue direct insurance policies across borders into other EU countries
• A captive can underwrite insurance coverage related to its parent’s European business without paying fronting fees or purchasing insurance from local insurers.
• Unlike Luxembourg (mostly reinsurance vehicles), Dublin captives can directly insure European-located risks without costly fronting arrangements
• Multi-captives formed in Dublin have U.S. corporations as parents
• Table 1 compares regulatory features/statistics of the three domiciles: Minimum capitalization rate, licensing fees, captive tax rates

Research Methodology

• The section identifies value from the formation of a captive in the three European domiciles via a scenario approach
• Japanese Insurance Law mandates Japan risks are insured by a licensed insurance company
• An offshore captive that insures Japan-located risk must act as a reinsurance captive which reinsures the parent's risk with a licensed Japanese insurer
• If a Japanese firm's subsidiary is in a country where the income tax rate is 20% or less, the country is considered a tax haven
• The corporation must consolidate net income in Japan/pay taxes according to the Japanese tax code if the country is a tax haven
• A corporation is unable to avoid tax through a subsidiary in a tax haven
• The 3 domiciles included in the study are Guernsey (zero tax), Luxembourg (30% tax rate) and Dublin (12.5% tax rate).
• Guernsey and Dublin are treated as “tax haven” countries, while Luxembourg is not
• The 2009 Japanese code was amended with a "foreign dividend exclusion"
• The code allows a multi-national corporation to consider 95% of dividends paid by its foreign subsidiary as nontaxable income (subsidiary needs to be owned at least 25% by a Japanese corporation)
• Only 5% of foreign income is taxed in Japan if paid back as dividends.

Base Case Scenario

• Captive formed as a reinsurance captive using a fronting arrangement in Japan, capitalized, and operates for four years in domiciles such as Guernsey, Luxembourg, and Dublin
• Calculate values created by a captive in each domicile
• Parent pays 5% of net premium written as fronting fee
• Captive creates a loss reserve to manage payment of losses independently without purchasing reinsurance coverage
• Captive operates until the fourth year and runs off until the sixth year to pay out all liabilities
• Captive liquidates in the seventh year

Loss and Claim Payout

• The parent’s expected loss for a year is ¥40 million and the claim payout is consistent at 25%, 50%, and 25%
• This means the total loss accrued for a year is ¥40 million, but the actual claim payments are its 25% for the year that the loss occurred, 50% for the next year, and 25% for the third year.
• Claims are assumed to be paid out over three years which all losses are paid out through the sixth year before the captive is liquidated in year seven

Net Premium

• Paid to the local insurer combines: expected loss amounts and underwriting expense
• The underwriting expense used is the industry-wide underwriting expense ratio of 33.8% for 2011
• Net Premium Written (NPW) charged to the risk can be calculated given the underwriting expense ratio (UER) by the calculation: NPW ＝ 1/(1−UER)
• The net premium written for the expected loss of ¥40 million is approximately ¥60.4 million
• This premium is consistent over the captive operation
• The net premium written paid to the captive is translated into the local currency (¥131.22 per Euro and ¥155.11 per British pounds as of 9/4/2013